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Valuing Bermudan options when asset returns are Levy processes

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  • Evis Këllezi
  • Nick Webber

Abstract

Evidence from the financial markets suggests that empirical returns distributions, both historical and implied, do not arise from diffusion processes. A growing literature models the returns process as a Levy process, finding a number of explicit formulae for the values of some derivatives in special cases. Practical use of these models has been hindered by a relative paucity of numerical methods which can be used when explicit solutions are not present. In particular, the valuation of Bermudan options is problematical. This paper investigates a lattice method that can be used when the returns process is Levy, based upon an approximation to the transition density function of the Levy process. We find alternative derivations of the lattice, stemming from alternative representations of the Levy process, which may be useful if the transition density function is unknown or intractable. We apply the lattice to models based on the variance-gamma and normal inverse Gaussian processes. We find that the lattice is able to price Bermudan-style options to an acceptable level of accuracy.

Suggested Citation

  • Evis Këllezi & Nick Webber, 2004. "Valuing Bermudan options when asset returns are Levy processes," Quantitative Finance, Taylor & Francis Journals, vol. 4(1), pages 87-100.
  • Handle: RePEc:taf:quantf:v:4:y:2004:i:1:p:87-100
    DOI: 10.1088/1469-7688/4/1/008
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    References listed on IDEAS

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    1. Adam W. Kolkiewicz & Fangyuan Sally Lin, 2017. "Pricing Surrender Risk in Ratchet Equity-Index Annuities under Regime-Switching Lévy Processes," North American Actuarial Journal, Taylor & Francis Journals, vol. 21(3), pages 433-457, July.
    2. Hatem Ben‐Ameur & Rim Chérif & Bruno Rémillard, 2020. "Dynamic programming for valuing American options under a variance‐gamma process," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(10), pages 1548-1561, October.
    3. Warren J. Hahn & James S. Dyer, 2011. "A Discrete Time Approach for Modeling Two-Factor Mean-Reverting Stochastic Processes," Decision Analysis, INFORMS, vol. 8(3), pages 220-232, September.
    4. Helin Zhu & Fan Ye & Enlu Zhou, 2013. "Fast Estimation of True Bounds on Bermudan Option Prices under Jump-diffusion Processes," Papers 1305.4321, arXiv.org.
    5. Xu Guo & Yutian Li, 2016. "Valuation of American options under the CGMY model," Quantitative Finance, Taylor & Francis Journals, vol. 16(10), pages 1529-1539, October.
    6. Paul Glasserman & Zongjian Liu, 2010. "Sensitivity Estimates from Characteristic Functions," Operations Research, INFORMS, vol. 58(6), pages 1611-1623, December.
    7. Kourouvakalis, Stylianos, 2008. "Méthodes numériques pour la valorisation d'options swings et autres problèmes sur les matières premières," Economics Thesis from University Paris Dauphine, Paris Dauphine University, number 123456789/116 edited by Geman, Hélyette.

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